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You invested in an RRSP? Wait, you what?!
November 4, 2018
Working in the investment industry, I sometimes forget how some things I take for granted are not always obvious to people outside it or who don’t have a lot of investment knowledge. For example, sometimes a Canadian investor would tell me something along the lines of “I’m invested in an RRSP at 2%”, followed usually by some variation of “What do you think?”. It takes me a few seconds to realize what they are talking about. What is revealing and annoying is that a lot of Canadians don’t realise they have choices when it comes to their Registered Retirement Savings Plans (RRSPs). I want to take the time to debunk this a little and show what alternatives there are compared to what is typically presented.
What some people aren’t aware of is that an RRSP is a type of account and you can hold almost any kind of investment in it, from individual stocks and bonds to mutual funds and even some types of private investments. The Canadian government allows a whole range of eligible securities for these accounts. However, depending on which financial institution you open an account with, you will likely get some restrictions on what you can invest in. In the big banks with which a lot of Canadian have their savings, they will typically first and foremost be offered to invest in a Guaranteed Investment Certificate (GIC) inside an RRSP. This would be what most people refer to when they talk about “2% RRSP”. GICs are considered very safe investments that are supposed to give a guaranteed return when they mature, hence the name. If an issuer defaults, the Canadian federal government guarantees the principal amount that you invested with any one institution up to $100,000. Some provinces might insure a larger amount depending on the issuing company. The catch is that GICs are not flexible: in most cases, the minimum amount to invest is $5,000, sometimes more, and your money cannot be withdrawn until maturity, barring some exceptions. For that inconvenience, as well as for the guarantee of not losing your principal, GICs offer a modest return. Right now, looking at Questrade’s bond bulletin, the average yield for a GIC maturing in 5 years is just above 3%. The biggest issue however is that GICs are very advantageous to the bank or issuing financial institution. They are a loan to the bank, which in return makes investments or loans to earn a return higher than the one you are getting. Bank branch employees, namely the “financial advisors” likely to be on site are incentivized to sell you GICs, regardless of whether or not these products are appropriate for you (they probably are not) or meet your needs and objectives (they probably don’t). They are often presented to branch customers as a “3% RRSP”, making it seem like there is little or no choice. It is much more accurate and useful to think of them as “RRSP account with a GIC in it”, I believe it starts off a frame of mind of thinking about different options before settling for plopping one’s money into a GIC and basically locking it up for years. When dealing with a bank, you are typically offered only that bank’s GIC products. Some offer far less returns than others. Whereas if you’re dealing with a discount broker or other financial institution, you will often be given the choice of GICs from several providers, therefore giving you the chance to shop for better returns and to diversify your holdings.
A word of caution. While plain-vanilla GICs have both pros and cons, I wholeheartedly disagree with the category of “index-linked” or “market-linked” GICs. In addition to the features of a regular GIC, these products offer a return based on the performance of a certain stock index, specified in the product. So, you have the potential to earn a return somewhat like that of a risky stock market while having your downside protected. However, the maximum interest is often capped to a certain amount. For example, a 5-year market-linked GIC that might offer a maximum cumulative return for its term of 40% even if its reference stock index went up 50% or more over that period, which is certainly very possible. You’ll also want to read the fine print to understand exactly what the reference index is and how it is calculated. In short, if you want higher returns, it is better and simpler to invest in an actual stock market fund.
As for regular GICs, while not bad, there are other options that could suit your needs better if you’re looking for investments that have relatively low risk. Namely, high quality bond mutual funds or bond exchange-trade funds are generally good options (high-yield or junk bond funds don’t belong in the same conversation due to their higher risk nature). Bond or fixed income funds are flexible in that they can be sold and withdrawn almost any time. They’re not guaranteed against loss of principal, but their chances of loss are very low provided you don’t trade them more frequently than their intended use. For example, don’t buy a long-term bond to hold it just for 6 months. But generally, these represent good alternatives to being locked in with a bank GIC. Shop around and don’t assume you have to settle for a “2% RRSP”.